Avoid Making These Mistakes in Item 5 of Your Franchise Disclosure Document

As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws. As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.

During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents (“FDDs”). Many of these mistakes, which can cause delays in a franchisor’s ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering – sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.

A common FDD mistake is failure to list all “Initial Fees” in Item 5. Item 5, entitled “Initial Fees,” is where a franchisor must disclose all initial fees paid by the franchisee, and the conditions under which the fees are refundable. “Initial Fees” are defined as “all fees and payments, or commitments to pay, for services or goods received from the franchisor or any affiliate before the franchisee’s business opens, whether payable in lump sum or installments.” A franchisor must also disclose whether the initial fees can be paid in installments, and what those payment terms are.

Many franchisors do not follow instructions and fail to list all initial fees in Item 5. These mistakes typically come in two varieties.

1. Common Mistake #1: Failure to List All Initial Fees Paid to the Franchisor

The first type of mistake is that the franchisor or its counsel assumes that “Initial Fees” means only the initial franchise fee paid by the franchisee (the fee franchisors charge franchisees for the right to enter into a franchise agreement). This is wrong because it ignores the other types of fees that are paid (or that the franchisee is committed to pay) to the franchisor prior to the franchisee’s business opening.

In some franchise systems, there can be a multitude of initial fees charged that need to be disclosed in Item 5. Some examples:

In connection with processing the franchisee’s application (running credit, doing a background check, etc.), the franchisor requires a deposit or “application fee.”

The franchisor charges a fee for the franchisee to attend initial training.

The franchisor requires (or has the right to require) the franchisee to pay a fixed amount directly to the franchisor so that the franchisor can conduct grand opening advertising for the franchisee.

The franchisor charges a technology start-up or other type of fee relating to the franchisee’s use of the franchisor’s point of sale or other software system.

This is only a partial list of the types of fees that can fall under the category of “initial fees.” I have seen many FDDs where franchisors will clearly charge these fees, but fail to list or disclose them in Item 5.

2. Common Mistake #2: Failure to List All Initial Fees Paid to the Franchisor’s Affiliates

The second type of common mistake is the franchisor lists only initial fees paid by the franchisee directly to the franchisor, but ignores the fees paid to the franchisor’s affiliates. The instructions for Item 5 clearly call for these fees to be disclosed, too. Remember, an “affiliate” is defined as “an entity controlled by, controlling, or under common control with, another entity.”

Some examples of fees paid to a franchisor’s affiliates:

The franchisee must purchase an initial stock of inventory from the franchisor’s affiliate.

The franchisor’s affiliate builds out the store for the franchisee (often referred to as a “turn key” franchise), and the franchisee pays the affiliate for the build-out.

The franchisee is required to pay the franchisor’s affiliate to buy or obtain the right to use the franchisor’s proprietary software system.

The franchisee buys an initial supply of marketing materials from the franchisor’s affiliate.

Again, these are just some examples of the types of fees that are paid to affiliates. If these fees are paid before the franchisee opens for business, they are “initial fees” and must be disclosed in Item 5.

Conclusion

Avoid making these common mistakes in Item 5 of your own FDD, and you will have an easier time of getting registered in the registration states.